Whats Next for the Dollar and Currencies?

By: Axel G. Merk, Merk Investments

In the short to medium term, the U.S. dollar and currencies are heavily influenced by what the Fed may be up to next. As the Federal Reserve (Fed) may be reading tealeaves as much as anyone else, we may be facing particularly high policy uncertainty that, in turn, reflects on elevated volatility in the bond and currency markets. The good news is that this may yield opportunities for the prudent investor.

The Fed

Taper vs. Tighten? Yellen vs. Summers? A little more than halfway through the year and there is much debate about the course of Fed policy with respect to winding down asset purchases (QE) and the timing of the first rate hike off of the zero lower bound. Part of the confusion stems from the fact that the Fed can’t read its traditional gauges, namely the market’s perception of how bonds should be priced. As the Fed manages much of the yield curve (short-term through long term rates), policy makers appear to be ever more focused on any new data point on the economy. Adding to the uncertainty is that Bernanke’s term is coming to an end on January 31, 2014 and President Obama looks set to nominate a successor this fall.

For starters, the word “tapering” for all of its repetition in the press may not be the right way to think about how the QE program will evolve from here. The idea of tapering implies a gradual reduction, i.e., if the Fed announces a reduction in monthly purchases it will be followed by further reductions until the program is entirely discontinued. Let’s not forget that the Fed exited QE 1 and QE 2 only to be followed with further QE. Rather than go on with QE 3, 4… etc., the Fed announced an opened ended QE program in September 2012, which was the start of what is called QE 3. Once the Operation Twist program ended in December 2012, the Fed initiated $45 billion per month in outright Treasury purchases in addition to the $40 billion per month in MBS purchases, “QE 3.1” if you will. After the tapering talk started, the Fed made clear that it may decrease or increase its monthly asset purchases going forward depending on the outlook for the labor market and inflation, or that it may decrease and then subsequently increase monthly purchases, perhaps heralding in the “QE 3.2” phase.

Also, tapering QE does not mean tightening policy in terms of short-term rates, and the Fed has recently made a concerted effort to make that distinction. The two, QE tapering and Fed funds rate policy, are seen by some as tied because tapering suggests a move towards normalization of policy that would eventually take the Fed funds rate off of the so-called zero lower bound. While there seems to be debate among Fed officials as to the efficacy of QE and the cost/benefit trade off, there seems to be consensus, certainly among the dovish camp which we believe is in control of today’s Fed, that rates should remain extraordinarily low well after QE ends and for a very long time in general.

Meanwhile, Bernanke has all but entered full-on lame duck status, in which case the future of QE will be set by his successor and the current talk may be moot. As with any public policy maker, Bernanke may be concerned about his legacy as he winds down his tenure as Fed Chair. As he looks to seal his legacy Bernanke may aim to highlight some improvement in the labor market, scale down monthly purchases, claim some partial victory with his QE policies, and leave the problem to his successor. Saying things are getting better and making the first move to withdraw his unprecedented easing policies may make sense, i.e., declare victory and withdraw (at least temporarily). In our view a steady tapering of the QE program is far from a foregone conclusion.

In any case, the most important question is who will succeed Bernanke. Janet Yellen, Larry Summers, and Donald Kohn appear to be the names on Obama’s short list. Summers has emerged as the President’s favorite, no doubt a seasoned Washington wheeler-dealer who just may be able to get what he wants. Nevertheless, Summers is a polarizing figure who has made a lot of enemies in Washington, and many in Congress and the news media have come out either for Yellen or specifically against Summers. While Summers does indeed appear to be Obama’s preferred choice, our view is that Yellen will more likely carry the day. We see Yellen as the likely candidate for a number of reasons: experience (Chair of Council of Economic Advisers, President of the San Francisco Fed, Fed Vice Chair), political affiliation (Democrat), gender (female), monetary policy ideology (dovish and people know where she stands). Most relevant to the market is her ideology, where she is regularly scored as more dovish than Bernanke. Any change in leadership would provide an opportunity for modifications to the policy and messaging of the Fed, which could have dramatic ramifications for the currency markets. As far as Summers is concerned, while without a doubt he would like to be able to check off “Fed Chair” on his bucket list, we think he is better positioned to influence Washington politics from outside rather than inside the Fed.

We believe this lingering uncertainty fosters volatility in all markets: with the longer term course of the Fed unclear, the markets have yet another excuse to over-interpret the news of the day rather than price risk in terms of a longer term trajectory of monetary policy.

As far as economic data are concerned, we believe the glass may be half full, even if the markets perceive some data points as the glass half empty. More to the point:

• As mortgage rates have risen substantially, odds are high that the housing recovery might stall. There’s little evidence of a building boom: instead, even as there has been upward momentum in prices, we believe the recovery was mostly driven by low interest rates. Bernanke has specifically pointed to this risk; we believe Bernanke, just as Yellen if she succeeds him, may further taper the taper talk should housing disappoint.
• Unemployment reports continue to paint a mixed picture. Ahead of the implementation of Obamacare, employers have an incentive to shift full-time jobs to part-time jobs, as no healthcare will need to be provided for part-time employees. Most recently, the average number of hours worked per week fell; even the hourly wage fell. And then there’s the persistently declining labor participation rate. In the past, Bernanke had shrugged off the low and declining labor participation rate as a sign of an ageing society; someone must have shown him a more detailed analysis, however, as the elderly are working more; but those in their prime working years appear participating less and less.
• Corporate earnings have done okay, but a number of sectors have had disappointing sales. It’s easy to blame what was generally a stronger dollar in the first half of the year for sub-par performance, but ultimately blaming currency swings may be be an excuse more than a cause for missing investor expectations. Weak sales suggest this economic recovery is not as strong as rising stock prices suggest.

In this context, there may be a lot of work for the markets to taper its taper expectations. As the dollar has risen on the backdrop of taper talk, we expect the greenback to face headwinds. On that note, should there be a strong economic recovery, the dollar might also weaken, as – historically – the dollar has often weakened in early to mid phases of an economic recovery; that’s because foreigners are less inclined to buy U.S. bonds when there’s a bond bear market.

Gold:

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